Crowdfunding: what it is and how it works

Vanessa Cowling, general counsel of VentureFounders, lifts the lid on crowdfunding.

It is a term used every day, but what is crowdfunding when you cut through the hype, the excitement, the trendy businesses and the stories in the press predicting cataclysmic losses and failures?

A brief search of the term “crowdfunding” on the internet very quickly shows that it means many different things to many different people, organisations and businesses.

In 2013, when crowdfunding was first gaining momentum in the market, in the consultation paper ‘The FCA’s regulatory approach to crowdfunding (and similar activities)’ the Financial Conduct Authority described crowdfunding as “a way in which people, organisations and businesses (including business start-ups) can raise money through online portals to finance or re-finance their activities and enterprises”.

At first glance, this is a pretty clear definition and division of the main sectors of the crowdfunding industry.

A diluted term

However, as the market has matured and more models have entered the alternative financing space, the term crowdfunding seems to have become diluted.

For a start, crowdfunding is used interchangeably with other similar concepts such as crowdsourcing, crowd finance, community financing, peer to business investment and peer to peer lending (which in turn is also confusingly known as marketplace lending or crowdlending as well as many other things).

For some, like the FCA, crowdfunding is an umbrella term used to describe the entire industry of funding. Likewise, the UK Crowdfunding Association represents crowdfunding platform providers of all types (donation, debt and equity).

Coverage of crowdfunding in the media is also mixed – whilst some commentators use the term more generically, some use it to describe loan-based investments and others use the term to describe equity investment based crowdfunding – a sub-set of investment based crowdfunding.

In recent letters to the FCA and the Prudential Regulatory Authority on crowdfunding, the Rt. Hon Andrew Tyrie MP (also the chairman of the Treasury Committee) appears to be predominantly concerned by the loan-based crowdfunding market, but uses the term crowdfunding (without distinguishing the difference) throughout.

Blurred lines

The lines get even more blurred as crowdfunding starts to become a global phenomenon – the concepts and the way that they are described in different countries and in different languages will inevitably start to merge, mingle and mould together.

The English, the French, the Spanish, the Swedish, the Italian and the German along with several other countries appear to have embraced the term crowdfunding. However, rightly or wrongly, the term will be assumed to mean the same thing in each of these countries.

But why does this matter? Should we be bothered that you say potato, I say patata?

Clarity, transparency

The answer is that at best, it is confusing for investors and at worst it is dangerous and misleading.

Clarity, transparency and openness should form the cornerstones of the crowdfunding industry.

Anything that might lead an investor to misunderstand what they are donating, buying or investing in, including what crowdfunding platforms can, may, might or could call themselves and the services/products that they are peddling should be made clear.

As well as carrying different levels of risk, the different models of crowdfunding have different purposes and fulfil different needs.

Donation based crowdfunding (and also arguably some forms of rewards based crowdfunding) are primarily altruistic in nature.

In contrast, investment or loan-based crowdfunding should ultimately be about making a return on your investment.

One thing that worries me is where ‘equity’ investments are bundled up with rewards or perks to make them more attractive but the ‘investor’ enjoys very limited rights and their investment is worthless.

Addressing the issue

The crowdfunding platforms are also worried too – the ‘crowdfunding’ tag is used too loosely.

As a result, the successes and, most importantly, the failures are unfairly shared by the industry as a whole.

And this will continue until there is better awareness about who does what within the crowdfunding ecosystem.

The issue was debated at the recent annual general meeting of the UK Crowdfunding Association.

Now is an opportune time to address this issue – following the issue of its policy statement on crowdfunding in March 2014, the FCA is due to carry out its review of the regulatory regime for crowdfunding this year.

VentureFounders would certainly welcome rules and/or guidance about what pigeon holes we should all be using.